China's Chip Binge

Will it become a tech powerhouse--or cause a world glut?

In the eastern city of Wuxi, on one side of the historic Grand Canal, barges heavy with grain ply the murky waters, much as they have for centuries. But not far from the ancient waterway, workers toil in brightly lit clean rooms for the Central Semiconductor Manufacturing Corp (CSMC). Since 1997, Taiwanese managers have run the silicon wafer fabrication plant of once-struggling, state-owned CSMC. Their goal seems audacious: to turn the facility into a world-class producer of made-to-order chips.

The strategy is paying off. Although CSMC's wafer fabs still aren't as advanced as those of Taiwan, Japan, or South Korea, they're operating flat-out at a time when the global semiconductor industry is in recession. That's because CSMC churns out lower-end chips in high demand by Chinese makers of calculators, clocks, and other gadgets. For chipmakers, "China is the place to go," raves CSMC President Robert N. Lee.

Enthusiasm for China's bid to become a global chip power spreads far beyond Wuxi. In Shanghai alone, plans have been announced for about a dozen plants that by 2005 will be capable of making a half-million wafers a month. Investors include Advanced Micro Devices and IBM, which are expanding their current operations--as well as ambitious newcomers such as Toshiba, Singapore's Chartered Semiconductor Manufacturing, and Taiwanese tycoon Winston Wong. Like CSMC, many of them are foundries, or plants dedicated to contract manufacturing--an industry pioneered by Taiwan Semiconductor Manufacturing Co. (TSMC ). Other big plants are in the works in Beijing, Shenzhen, and Leshan in Sichuan Province. The Chinese government is helping the drive with tax breaks, while cities around the country are offering cheap land in new industrial parks in the hopes of becoming future Silicon Valleys.

Why binge on plants when the global industry is drowning in chips? Because China is one of the world's hottest growth markets for semiconductors. Domestic sales of computers, air conditioners, DVD players, and other products that need chips continue to surge. China also is a rising exporter of everything from wireless phones to computer peripherals--especially now that it belongs to the World Trade Organization. Merrill Lynch & Co. predicts that China's chip market will grow about 25% annually for the next four years, double the worldwide rate, to $43 billion.

By putting new plants in China, chipmakers can be closer to their customers. Currently, China imports 90% of its semiconductors. If it can reduce imports to 70%, its chip output will surge from $1.2 billion in 2000 to $13 billion in 2005. "This place will be one of the biggest integrated-circuit manufacturing centers in the world," predicts Grace Semiconductor Manufacturing Corp. President Nava Tsai, a former top executive of Taiwanese chipmaker Mosel Vitalic. Grace, a Shanghai venture involving Taiwan's Wong, is building a $1.6 billion plant.

In the boom-and-bust chip industry, China's dreams don't come without big risks. From Malaysia to South Korea, huge wafer fabs built by ambitious tycoons and governments sit idle or severely underutilized. Even foundry king TSMC is operating at less than half-capacity. A glut of new Chinese plants could depress prices. "If we all blindly set up new factories, that's going to be a problem," observes CSMC Chairman Peter Chen. That notion is already spooking investors: Both CSMC and NEC Corp., which has a stake in chip foundry Shanghai Hua Hong NEC Electronics Co., postponed plans to list their shares last year.

China's chip industry also has a lot of catching up to do. Despite China's WTO membership, an international agreement still bars U.S., European, and Japanese companies from selling China the most sophisticated manufacturing equipment out of concern that the machines will be used for military purposes. That means it will be hard for Chinese companies to match overseas rivals at the top end of the market, where the biggest profits are. The Chinese "will be a couple of generations behind," says C.D. Tam, Hong Kong-based president of Motorola Asia Pacific. For example, Taiwanese foundries are racing into production with 30-cm. silicon wafers, a cutting-edge technology that yields many more chips at a lower price. China's most advanced plants will make 20-cm. wafers. Chinese factories also can't import equipment to make chips with circuits as narrow as 0.18 microns; Taiwanese rivals already have moved into 0.13 microns, widths that allow them to cram more circuitry onto a chip.

Still, long-term economics should work in China's favor. By 2005, China has pledged to lift all tariffs on most infotech products. Local chipmakers will face tougher competition--but will be able to import equipment and materials more cheaply. Moreover, foreign electronics companies are rapidly shifting manufacturing to China. So chip consumption should explode. If you are a big chip company, "it's not a question of whether you will be in China, but when," says Peter Tsao, Deutsche Bank's head of hardware technology investment banking in Hong Kong.

What's more, the biggest demand in China is for chips used in consumer electronics, PCs, and home appliances, basic devices relying on "lagging-edge technologies" that local plants can readily handle, says Semiconductor Manufacturing International Corp. (SMIC) CEO Richard R. Chang. SMIC has grander ambitions. It has just opened a $1.5 billion 20-cm. fab and announced Toshiba and Chartered would be equity partners in the company. Since China still lacks experienced engineers, Chang has hired about 450 staff overseas--and built a bilingual school to educate their children. "We guarantee the same performance" as Taiwanese foundries, Chang vows.

The arrival of Chartered and Toshiba should increase pressure on TSMC and United Microelectronics Corp.--the two giants of the foundry business--to follow suit. Both Taiwanese companies want to invest in China but have been stymied by the island's government, which is wary of losing key industries to the mainland.

Western companies are pushing ahead, too. Motorola is building a fab in the northern city of Tianjin. Phoenix-based On Semiconductor is investing in one in Sichuan province. Philips and Nortel have stakes in Shanghai's Advanced Semiconductor Manufacturing Corp. (ASMC), which is building a $750 million fab. Intel and Fairchild Semiconductor are adding chip assembly and testing plants. The global chip slump helps the burgeoning facilities in one regard: Prices for new equipment have dropped by about half in a year. "Everything is cheap," says ASMC Operations Vice-President Gao Zhoumiao.

China's chip drive is shaping up to be one of its boldest moves yet. It could greatly accelerate China's growth as an industrial power--or it could create a monstrous glut. China has already transformed global industries from apparel to consumer electronics. For good or for ill, the same is about to happen to chips.

By Bruce Einhorn in Wuxi

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